Oil: Where is the spare capacity?

I am in the same camp with Jeremy Grantham. Call it peak resources, peak oil, the end of cheap oil, whatever – the fact is there is a finite amount of natural resources on the planet and we are consuming an inordinate amount of it. At some point, the demand for these resources will outstrip the affordable supply. This naturally induces a parabolic move in price due to inelastic demand – and that’s when the Easter island question presents itself:

With a dwindling supply of natural resources available,

Do we have the foresight to plan ahead and reduce reliance on these dwindling resources?

Do we see a ‘nationalistic’ response and resource grab that increases political tension and brings in the spectre of military confrontation?

Or do we see a class struggle of the energy have-nots against the energy haves?

At least over the short-to-medium term, my view is that

[t]he rise in food and energy prices should be taken into consideration by government officials conducting pro-inflationary policies. What should be of concern regarding commodity price inflation is how it represents a regressive tax on lower income workers and consumers in emerging markets and developing countries. Lower income consumers spend a much greater percentage of income on food and energy. So when commodity prices increase, it has a disproportionate effect on them. One reason we saw food riots in emerging markets in 2008 has much to do with this.

Right now, oil supplies are tight at current prices and that is creating the parabolic move higher, aided significantly by speculation. I would argue that the conflicts in the Middle East right now should not be seen merely as democratic convulsions of people striving for greater liberty, but rather a natural consequence of increased population and energy consumption. It is a manifestation of the Easter Island question: when the resources of your world dwindle to a point at which not everyone can continue to enjoy the same lifestyle, how does society react?

In 2009, I argued:

we don’t need a conspiracy theory to see that the end of cheap oil is upon us. To find high quality oil deposits (I am not talking about Oil Sands in Alberta here) is becoming more and more expensive. And one oil field after another is hitting peak. We have seen it in Mexico, Russia, the North Sea, the Alaskan North Slope and elsewhere. The only thing keeping us from realizing the peak is Saudi Arabia, the swing producer in OPEC.

Saudi oil production (chart 1) grew aggressively over the last 5 months. By February it was similar to the 2008 peak and just 250,000bpd off its 2004 peak – (Bloomberg data goes back to 1990). This was before the Libyan production was turned off and so has raised questions about whether the production Saudi has said it would bring on stream in response to Libya was already encompassed in these figures.

During February Libya’s production fell from 1.585m bpd to 1.385m bpd. As far as I am aware the rest, or at least the majority of the rest has since been lost. If Saudi Arabia was able to cover this by itself that would take Saudi production to 1.135m bpd or 12% more than its 2004 peak, ie totally unchartered territory. Saudi’s own domestic demand has been rising over the years limiting any growth in its exports and now with the King writing cheques to his population equivalent of over USD10bbl or about 10% of its proceeds, presumably domestic consumption of oil will rise by a similar amount meaning that production would have to rise still further over the previous peak to have a positive impact on exports.

The Saudis have a huge population explosion and that requires a lot of natural resources. The same is true all across the Middle East. Moreover, with civil unrest a real concern, the Saudis are spending tens of billions to mollify their citizens. So I do think we should ask whether the Saudis can rise to the occasion. Do they have the spare capacity? The WikiLeaks cables suggest there is reason for doubt.

You will have seen today that Iraq is to add 5GW of diesel generator capacity, almost doubling its power output and giving it sufficient power to meet 16 hours of daily demand getting it back to a more normal level – (generators being supplied by MAN diesel and Caterpillar). In the long term that may help boost domestic oil production but in the short term it is likely to increase domestic oil demand by around 200,000 bpd if I have done my calculations correctly.

Russian oil production (chart 2) which accounted for about 60% of the growth in global oil production over the last 10 years as it recovered from the collapse in the early 1990’s when the Soviet Union fell apart, has been fairly flat since 2006 despite the surging oil prices and is actually down since October (I have ignored February as a seasonal fall). Production is still 700,000 bpd lower than the high in 1990 when Bloomberg records start. It seems unlikely that Russia has much ability to bring more production to the market in the short term particularly given it was unable to do so in 2008 when prices were a lot higher. Since June last year China has managed to grow its production by 225,000 bpd but that is only 5.8% so not enough to meet it own demand growth.

It seems highly unlikely to me that Libya’s shortfall can be made up and even if it can, it seems like the Middle East themselves are going to be consuming an ever greater proportion of their own output. In 2007/08 OECD inventories bottomed at 50.7 days cover in December 2007 compared with this January’s 58.2 days cover so that does offer some protection but it seems that this is another supply chain that really cannot afford any further disruption. Remember the US Joint Forces Command has warned "By 2012 surplus oil production capacity could entirely disappear and as early as 2015, the shortfall in output could reach nearly 10mbpd" and the US DOE has warned of the possibility of the world suffering a decline in world liquids production between 2011 and 2015.

As the 3rd chart shows oil did over-do-it on the upside in 2008 and then the correction, but the trend is very much still in place and it is just in the middle of a rough trend. With greater excess liquidity levels than 3 years ago (household savings, corporate cash and most importantly bank capital ratios) and the Fed unlikely to raise rates until unemployment has a proper fall, it seems it is still too early to abandon oil.

Unless we see demand destruction and recession, I don’t see why oil would drop significantly from here. When the Fed stops flooding the market with liquidity, things will change.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

I have to agree. The Saudi’s could have reached peak production within the last few years, and simply are unable to increase supply to bring prices down. It was high oil prices, along with unemployment and other factors, which made life tough for the locals that kick-started the revolutions. I do not think that we will see an end to this, soon. As revolutions create higher oil prices, sparking more revolutions, and ultimately recessions in the west as oil prices take their toll.

Longer term renewables will have to take up the slack in the west while nuclear options are debated.

Anonymous says 8 years ago

I have to agree. The Saudi’s could have reached peak production within the last few years, and simply are unable to increase supply to bring prices down. It was high oil prices, along with unemployment and other factors, which made life tough for the locals that kick-started the revolutions. I do not think that we will see an end to this, soon. As revolutions create higher oil prices, sparking more revolutions, and ultimately recessions in the west as oil prices take their toll.

Longer term renewables will have to take up the slack in the west while nuclear options are debated.

fresnodan says 8 years ago

I used to be very concerned about oil….in 1978. I really bought that the world is running out of oil. I believe in real terms gasoline was cheapest EVER in 1999 or so.
If you look at newsreels of New York 1910, it is quite bustling. No cars. People got around.

2000 miles per gallon car …not 200 but 2000!https://www.shortnews.com/start.cfm?id=63929
Sure, people would rather have 300 horsepower instead of two, and would like to go faster than 30 mph. But if gas starts costing…what, 10$ a gallon? 25$ a gallon?? 100$ a gallon???
We will adjust. We may not like the adjustment, there might be pain, but the vast majority of human history has been lived without automobiles.

One way to look at this is to ask the question whether we could double the number of people on earth with American living standards without any sort of energy supply constraint. I think the likely answer is no. But that’s where we are headed, or at least that’s where the Chinese and the Indians and the Brazilians want to head.

The question that then must be answered is this: what happens when the rising living standards of so many creates a energy supply constraint? How does it get resolved? That’s the Easter Island question. My answer is that the energy ‘haves’ will protect their supplies and the status quo at all costs. The constant meddling in the Middle East is a sign that this is true. And I think that leads to more volatile oil prices, a more volatile world and increase tensions.

So, yes, there will be an adjustment. There must be. Over what time frame will that adjustment occur ad what will the outcome be? My answer is it will be a long period of adjustment and conflict is likely. Beyond that, it’s anyone’s guess.

Cheers.

Edward

Anonymous says 8 years ago

The adjustment can be viewed at two levels. The high level view is that decades from now most of the world’s population will live their lives making do with far less fossil fuel energy. What is more worrying is what happens to make this transition come about when viewing at the low level. The utopian view is that most individuals will make the choice to give up an old way of life, and voluntarily derive happiness from an alternative way of living. The opposite extreme is that most individuals will cling to what they know, and then there will be a “selection process” whereby a lucky few will end up making it through “the adjustment” relatively unscathed — The quoted terms being euphemisms for whatever horrific actions humans devise to inflict unto each other. At the high level, the end result is the same — “We will adjust.” but it is the lower level details that determine exactly how fresnodan’s pronoun “We” will be defined.

The US is particularly vulnerable because of the sway of the auto and oil lobbies in Washington. The price of oil in Europe and Japan is not so much of an issue because they are considerably more oil efficient. Because of the lobbying against gas taxes the US has failed to adjust to the change, and when that change happens the US will be even less prepared than any other western country. You have avoided the pain so far but when it comes it will be much worse in the US than elsewhere.

Anonymous says 8 years ago

I used to be very concerned about oil….in 1978. I really bought that the world is running out of oil. I believe in real terms gasoline was cheapest EVER in 1999 or so.
If you look at newsreels of New York 1910, it is quite bustling. No cars. People got around.

2000 miles per gallon car …not 200 but 2000!https://www.shortnews.com/start.cfm?id=63929
Sure, people would rather have 300 horsepower instead of two, and would like to go faster than 30 mph. But if gas starts costing…what, 10$ a gallon? 25$ a gallon?? 100$ a gallon???
We will adjust. We may not like the adjustment, there might be pain, but the vast majority of human history has been lived without automobiles.

One way to look at this is to ask the question whether we could double the number of people on earth with American living standards without any sort of energy supply constraint. I think the likely answer is no. But that’s where we are headed, or at least that’s where the Chinese and the Indians and the Brazilians want to head.

The question that then must be answered is this: what happens when the rising living standards of so many creates a energy supply constraint? How does it get resolved? That’s the Easter Island question. My answer is that the energy ‘haves’ will protect their supplies and the status quo at all costs. The constant meddling in the Middle East is a sign that this is true. And I think that leads to more volatile oil prices, a more volatile world and increase tensions.

So, yes, there will be an adjustment. There must be. Over what time frame will that adjustment occur ad what will the outcome be? My answer is it will be a long period of adjustment and conflict is likely. Beyond that, it’s anyone’s guess.

Cheers.

Edward

Anonymous says 8 years ago

The adjustment can be viewed at two levels. The high level view is that decades from now most of the world’s population will live their lives making do with far less fossil fuel energy. What is more worrying is what happens to make this transition come about when viewing at the low level. The utopian view is that most individuals will make the choice to give up an old way of life, and voluntarily derive happiness from an alternative way of living. The opposite extreme is that most individuals will cling to what they know, and then there will be a “selection process” whereby a lucky few will end up making it through “the adjustment” relatively unscathed — The quoted terms being euphemisms for whatever horrific actions humans devise to inflict unto each other. At the high level, the end result is the same — “We will adjust.” but it is the lower level details that determine exactly how fresnodan’s pronoun “We” will be defined.

The US is particularly vulnerable because of the sway of the auto and oil lobbies in Washington. The price of oil in Europe and Japan is not so much of an issue because they are considerably more oil efficient. Because of the lobbying against gas taxes the US has failed to adjust to the change, and when that change happens the US will be even less prepared than any other western country. You have avoided the pain so far but when it comes it will be much worse in the US than elsewhere.

Anonymous says 8 years ago

Ed,

The peaking of global petroleum production, while representing a fundamental change, is so obvious that it is less interesting to me now than several years ago when the mainstream media ignored or riduculed the notion of peak oil. What is interesting is the emerging discussion of the transition to a post-carbon, steady state future. The just published “Fleeing Vesuvius” offers an overview of this topic in a compilation of essays by the authors researching and writing about it for the past several years. I only received the book several days ago but it looks like a good starting point for thinking about what transition looks like and how it can be accomplished.

The peaking of global petroleum production, while representing a fundamental change, is so obvious that it is less interesting to me now than several years ago when the mainstream media ignored or riduculed the notion of peak oil. What is interesting is the emerging discussion of the transition to a post-carbon, steady state future. The just published “Fleeing Vesuvius” offers an overview of this topic in a compilation of essays by the authors researching and writing about it for the past several years. I only received the book several days ago but it looks like a good starting point for thinking about what transition looks like and how it can be accomplished.